Japan's Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending

Japan's interest rates have been compressed toward zero because of pressure coming through the foreign exchanges. Twenty years of current‐account surpluses have led to a huge buildup of claims – mainly dollars – on foreigners. Because of ongoing fluctuations in the yen/dollar exchange rate, Japanese financial institutions will only willingly hold these dollar claims if the nominal yield on them is substantially higher than on yen assets. In the 1990s to 2002 as US interest rates have come down, portfolio equilibrium has been sustained only when nominal interest rates on yen assets have been forced toward zero. One consequence is the now infamous liquidity trap for Japanese monetary policy. A second consequence is the erosion of the normal profit margins of Japan's commercial banks, leading to a slump in new bank credit and an inability to grow out of the overhang of old bad loans.